©2007, The McGraw-Hill Companies, All Rights Reserved 22-1 McGraw-Hill/Irwin Chapter Twenty-two...

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22-1 McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved Chapter Twenty- two Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet

Transcript of ©2007, The McGraw-Hill Companies, All Rights Reserved 22-1 McGraw-Hill/Irwin Chapter Twenty-two...

Page 1: ©2007, The McGraw-Hill Companies, All Rights Reserved 22-1 McGraw-Hill/Irwin Chapter Twenty-two Managing Interest Rate Risk and Insolvency Risk on the.

22-1McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved

Chapter Twenty-two Managing Interest Rate

Risk and Insolvency Risk on the Balance Sheet

Page 2: ©2007, The McGraw-Hill Companies, All Rights Reserved 22-1 McGraw-Hill/Irwin Chapter Twenty-two Managing Interest Rate Risk and Insolvency Risk on the.

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Interest Rate Risk Measurement

• Repricing or funding gap

• Rate Sensitivity– the time to reprice an asset or liability– a measure of an FI’s exposure to interest rate

changes in each maturity “bucket”– GAP can be computed for each of an FI’s maturity

buckets

• Repricing or funding gap

• Rate Sensitivity– the time to reprice an asset or liability– a measure of an FI’s exposure to interest rate

changes in each maturity “bucket”– GAP can be computed for each of an FI’s maturity

buckets

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Calculating GAP for a Maturity Bucket

NIIi = (GAP)i Ri = (RSAi - RSLi) Ri

where NIIi = change in net interest income in the ith maturity bucket GAPi = dollar size of the gap between the book value of rate-sensitive assets and rate- sensitive liabilities in maturity bucket i Ri = change in the level of interest rates impacting assets and liabilities in the ith maturity bucket

NIIi = (GAP)i Ri = (RSAi - RSLi) Ri

where NIIi = change in net interest income in the ith maturity bucket GAPi = dollar size of the gap between the book value of rate-sensitive assets and rate- sensitive liabilities in maturity bucket i Ri = change in the level of interest rates impacting assets and liabilities in the ith maturity bucket

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Simple Bank Balance Sheet and Repricing Gap

Assets Liabilities_________1. Cash and due from $ 5 1. Two-year time deposits $ 402. Short-term consumer 50 2. Demand deposits 40 loans (1 yr. maturity) 3. Long-term consumer 25 3. Passbook Savings 30 loans (2 yr. maturity)4. Three-month T-bills 30 4. Three-month CDs 405. Six-month T-notes 35 5. Three-month banker’s 20 acceptances6. Three-year T-bonds 60 6. Six-month commercial 607. 10-yr. Fixed-rate mort. 20 7. One-year time deposits 208. 30-yr. Floating-rate m. 40 8. Equity capital (fixed) 209. Premises 5 $270 $270

Assets Liabilities_________1. Cash and due from $ 5 1. Two-year time deposits $ 402. Short-term consumer 50 2. Demand deposits 40 loans (1 yr. maturity) 3. Long-term consumer 25 3. Passbook Savings 30 loans (2 yr. maturity)4. Three-month T-bills 30 4. Three-month CDs 405. Six-month T-notes 35 5. Three-month banker’s 20 acceptances6. Three-year T-bonds 60 6. Six-month commercial 607. 10-yr. Fixed-rate mort. 20 7. One-year time deposits 208. 30-yr. Floating-rate m. 40 8. Equity capital (fixed) 209. Premises 5 $270 $270

Page 5: ©2007, The McGraw-Hill Companies, All Rights Reserved 22-1 McGraw-Hill/Irwin Chapter Twenty-two Managing Interest Rate Risk and Insolvency Risk on the.

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Additional Terminology

• Cumulative gap (CGAP): the cumulative GAP across various repricing categories or buckets

• Spread effect: the effect that a change in the spread between rates on RSAs and RSLs has on net interest income (NII) as interest rates change

• Cumulative gap (CGAP): the cumulative GAP across various repricing categories or buckets

• Spread effect: the effect that a change in the spread between rates on RSAs and RSLs has on net interest income (NII) as interest rates change

Page 6: ©2007, The McGraw-Hill Companies, All Rights Reserved 22-1 McGraw-Hill/Irwin Chapter Twenty-two Managing Interest Rate Risk and Insolvency Risk on the.

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Four Major Weakness in the Repricing Model

• Market value effects

• Cash flow patterns within a maturity bucket

• The problems of rate runoffs and prepayments

• Cash flows from off-balance-sheet activities

• Market value effects

• Cash flow patterns within a maturity bucket

• The problems of rate runoffs and prepayments

• Cash flows from off-balance-sheet activities

Page 7: ©2007, The McGraw-Hill Companies, All Rights Reserved 22-1 McGraw-Hill/Irwin Chapter Twenty-two Managing Interest Rate Risk and Insolvency Risk on the.

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Duration Model

Duration gap - a measure of overall interest rate risk exposure for an FI

D = _ % in the market value of a security R(1 + R)

Duration gap - a measure of overall interest rate risk exposure for an FI

D = _ % in the market value of a security R(1 + R)

Page 8: ©2007, The McGraw-Hill Companies, All Rights Reserved 22-1 McGraw-Hill/Irwin Chapter Twenty-two Managing Interest Rate Risk and Insolvency Risk on the.

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Difficulties in Applying the Duration Model

• Duration matching can be costly

• Immunization is a dynamic problem

• Large interest rate changes and convexity

• Duration matching can be costly

• Immunization is a dynamic problem

• Large interest rate changes and convexity

Page 9: ©2007, The McGraw-Hill Companies, All Rights Reserved 22-1 McGraw-Hill/Irwin Chapter Twenty-two Managing Interest Rate Risk and Insolvency Risk on the.

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Insolvency Risk Management

• Net worth

• Book Value

• Market value or mark-to-market value basis

• Net worth

• Book Value

• Market value or mark-to-market value basis

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Effects of Changes in Loan Values and Interest Rates on the Balance Sheet

Assets Liabilities Base case Long-term securities $ 80 Short-term floating $ 90 Long-term bonds 20 Net worth 10 $100 $100 After a major decline in value of loans Long-term securities $ 80 Liabilities $90 Long-term bonds 8 Net worth -2 $88 $88 After a rise in interest rates Long-term securities $ 75 Liabilities $90 Long-term loans 17 Net worth 2 $92 $92

Assets Liabilities Base case Long-term securities $ 80 Short-term floating $ 90 Long-term bonds 20 Net worth 10 $100 $100 After a major decline in value of loans Long-term securities $ 80 Liabilities $90 Long-term bonds 8 Net worth -2 $88 $88 After a rise in interest rates Long-term securities $ 75 Liabilities $90 Long-term loans 17 Net worth 2 $92 $92

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The Book Value of Capital

• The book value of capital usually comprises three components in banking– Par value of shares– Surplus value of shares – Retained earnings

• Book value of its capital and credit risk

• Book value of capital and interest rate risk

• The book value of capital usually comprises three components in banking– Par value of shares– Surplus value of shares – Retained earnings

• Book value of its capital and credit risk

• Book value of capital and interest rate risk

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The Discrepancy between the Market and Book Values of Equity

• The degree to which the book value of an FI’s capital deviates from its true economic market value depends on a number of values– Interest Rate Volatility

– Examination and Enforcement

– Loan Trading

• The degree to which the book value of an FI’s capital deviates from its true economic market value depends on a number of values– Interest Rate Volatility

– Examination and Enforcement

– Loan Trading

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Calculating Discrepancy Between Book Values (BV) and Market Values (MV)

MV = Market value of equity ownership in shares outstanding Number of shares

Par value of equity + Surplus value + BV = Retained earnings_ ________ Number of shares

Market-to-book ratio A ratio that shows the discrepancy between the stock market value of an FI’s equity and the book value of its equity

MV = Market value of equity ownership in shares outstanding Number of shares

Par value of equity + Surplus value + BV = Retained earnings_ ________ Number of shares

Market-to-book ratio A ratio that shows the discrepancy between the stock market value of an FI’s equity and the book value of its equity

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Arguments against Market Value Accounting

• Difficulty of implementation

• Introduces unnecessary degree of variability into an FI’s net worth

• FI’s are less willing to accept longer-term asset exposures

• Difficulty of implementation

• Introduces unnecessary degree of variability into an FI’s net worth

• FI’s are less willing to accept longer-term asset exposures


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